Calls Options, Puts Options, and Shares

Investors regularly trade options on common stocks.[1] For example, Table 20.1 reproduces quotes for options on the stock of Amazon.com. You can see that there are two types of options—calls and puts. We explain each in turn. 1. Call Options and Position Diagrams A call option gives its owner the right to buy stock

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Financial Alchemy with Options

Look now at Figure 20.4a, which shows the payoff if you buy Amazon stock at $900. You gain dollar-for-dollar if the stock price goes up and you lose dollar-for-dollar if it falls. That’s trite; it doesn’t take a genius to draw a 45-degree line. Look now at panel (b), which shows the payoffs from

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What Determines Option Values?

So far we have said nothing about how the market value of an option is determined. We do know what an option is worth when it matures, however. Consider, for instance, our earlier example of an option to buy Amazon stock at $900. If Amazon’s stock price is below $900 on the exercise date,

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A Simple Option-Valuation Model

1. Why Discounted Cash Flow Won’t Work for Options For many years, economists searched for a practical formula to value options until Fischer Black and Myron Scholes finally hit upon the solution. Later we will show you what they found, but first we should explain why the search was so difficult. Our standard procedure

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The Binomial Method for Valuing Options

The essential trick in pricing any option is to set up a package of investments in the stock and the loan that will exactly replicate the payoffs from the option. If we can price the stock and the loan, then we can also price the option. Equivalently, we can pretend that investors are risk-neutral,

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The Black-Scholes Formula for Valuing Options

Look back at Figure 21.1, which showed what happens to the distribution of possible Amazon stock price changes as we divide the option’s life into a larger and larger number of increas­ingly small subperiods. You can see that the distribution of price changes becomes increas­ingly smooth. If we continued to chop up the option’s

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Black-Scholes in Action

To illustrate the principles of option valuation, we focused on the example of Amazon’s options. But financial managers turn to the Black-Scholes model to estimate the value of a variety of different options. Here are four examples. 1. Executive Stock Options In fiscal year 2017, Larry Ellison, the CEO of Oracle Corporation, received a

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Option Values at a Glance

So far, our discussion of option values has assumed that investors hold the option until matu­rity. That is certainly the case with European options that cannot be exercised before maturity but may not be the case with American options that can be exercised at any time. Also, when we valued the Amazon call, we

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The Option Menagerie

Our focus in the past two chapters has been on plain-vanilla puts and calls or combina­tions of them. An understanding of these options and how they are valued will allow you to handle most of the option problems that you are likely to encounter in corporate finance. However, you may occasionally encounter some more

The Value of Follow-On Investment Opportunities

It is 1982 and the first personal computer has recently been launched. You are assistant to the chief financial officer (CFO) of Blitzen Computers, an established computer manufacturer casting a profit-hungry eye on the PC market. You are helping the CFO evaluate the proposed introduction of the Blitzen Mark I Micro. The Mark I’s

The Timing Option

The fact that a project has a positive NPV does not mean that you should go ahead today. It may be better to wait and see how the market develops. Suppose that you are contemplating a now-or-never opportunity to build a malted herring factory. In this case, you have an about-to-expire call option on

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The Abandonment Option

Expansion value is important. When investments turn out well, the quicker and easier the business can be expanded, the better. But suppose bad news arrives, and cash flows are far below expectations. In that case, it is useful to have the option to bail out and recover the value of the project’s plant, equipment,

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Flexible Production and Procurement

Flexible production means the ability to vary production inputs or outputs in response to fluc­tuating demand or prices. Take the case of CT (combustion-turbine) generating plants, which are designed to deliver short bursts of peak-load electrical power. CTs can’t match the thermal efficiency of coal or nuclear power plants, but CTs can be turned

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Investment in Pharmaceutical R&D

An investment in research and development (R&D) is really an investment in real options. When your research engineers invent a better mousetrap, they hand you an option to manufac­ture and sell it. New and improved mousetraps can be engineering triumphs but commercial failures. You will make the investment to manufacture and launch the better

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Valuing Real Options

In this chapter, we have presented several examples of important real options. In each case, we used the option-pricing methods developed in Chapter 21, as if the real options were traded calls or puts. Was it right to value the real options as if they were traded? Also we said next to nothing about

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Yields on Corporate Debt

The year 2017 was not a happy one for telecom operator, Frontier Communications. Its share price fell by 85% over the year, and its 11% bonds maturing in 2025 were trading at 79% of face value, where they offered a yield to maturity of 15.8%. A naive investor who compared this figure with the

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Valuing the Option to Default

The difference between a corporate bond and a comparable Treasury bond is that the com­pany has the option to default whereas the government supposedly doesn’t.[1] That default option is valuable. If you don’t believe us, think about whether (other things equal) you would prefer to be a shareholder in a company with limited liability

Bond Ratings and the Probability of Default

Banks and other financial institutions not only want to know the value of the loans that they have made, but they also need to know the risk that they are incurring. Some rely on the judgments of specialized bond rating services. Others have developed their own models for measuring the probability that the borrower

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Predicting the Probability of Default

1. Statistical Models of Default If you apply for a credit card or a bank loan, you will probably be asked to complete a ques­tionnaire that provides details about your job, home, and financial health. This information is then used to calculate an overall credit score.[1] If you do not make the grade on the

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Long-Term Bonds

1. Bond Terms Applied Materials (AMAT) supplies equipment and software for the manufacture of semi­conductors. In 2011, AMAT issued 30-year bonds to help finance an acquisition. The bond was a plain-vanilla issue; in other words, it was pretty well standard in every way. To give you some feel for the bond contract (and for

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